How Would Fed Deal With Debt Ceiling Crisis? Look to Minutes for Clues

Federal Reserve officials could provide some clarity on how they might handle a debt ceiling crisis when they release minutes of their October policy meeting Wednesday.

Associated Press

Federal Reserve building in Washington.

The policy meeting happened just after the standoff between congressional Republicans and the White House over budget issues last month. If history is any guide, Fed officials likely had extensive talks about their plans for a debt ceiling crisis in the days leading up to that meeting, or at the meeting itself, and the minutes could reveal how their thinking has evolved.

Officials faced a similar dilemma in August 2011, the last time the White House ran into a standoff with Republicans over allowing the government to continue to borrow to fund its operations. Minutes from the August 8, 2011 policy meeting showed officials held a special videoconference before it and dropped clues about how officials might approach the event.

The challenge the Fed faced on both occasions was deciding whether to intervene in financial markets if the Treasury were to miss payments on U.S. government debt because Treasury had hit the government’s borrowing limit.

Officials and investors largely agree that a missed payment on U.S. debt would be hugely disruptive in markets. Treasury debt is like oxygen in global markets. It is held not just as an asset in the portfolios of insurance companies, households and foreign central banks, but also as collateral for short-term loans among hedge funds, big investment banks and others. Moreover, bond dealers and banks could struggle to overcome simple logistical challenges if the Treasury were to miss a payment, such as transferring delinquent bonds from one back to another.

The Fed and the Treasury have been highly secretive about their emergency plans, leaving investors and the broader public in the dark about how they would handle a debt ceiling crisis.

Fed Chairman Ben Bernanke has said the central bank couldn’t bail the country out from the shock of a missed payment. But analysts and people familiar with the Fed’s operations say there are a range of steps it could in theory take to alleviate short-term disruptions in markets.

For instance the Fed could accept delinquent Treasury bonds as collateral at its discount window in exchange for short-term cash loans to banks. That might alleviate pressure on banks holding these securities. It might also accept delinquent Treasury bonds in open market operations with bond dealers to alleviate repercussions in short-term lending markets. The Fed also sometimes conducts securities lending operations with Wall Street banks in which it temporarily loans Treasury securities out of its portfolio to help address short-term market shortages. In theory the Fed could also buy delinquent bonds as part of its bond-buying program known as quantitative easing.

The big underlying question with all of these potential approaches is whether the central bank in a crisis would see Treasury securities as money-good or as tarnished. If they’re seen as money-good, they could in theory be used in a wide range of transactions with the Fed, but if they’re judged as tarnished their value in transactions with the Fed could be dented.

The Federal Reserve Act requires that it accept collateral that is “secured to the satisfaction” of the central bank, but it doesn’t specify what is satisfactory. The Fed already takes a wide range of securities as collateral, but it attaches different values to that collateral, with Treasury securities being deemed safer than other securities, such as corporate debt or municipal bonds.

Minutes of a special Fed videoconference meeting on Aug. 1, 2011 say officials agreed that in a crisis the Fed should stick to its “standard operations.” They also agreed that any steps would depend on market conditions and that among the options discussed were changes to its discount window operations and open market operations. That implies — but doesn’t state clearly — that they considered actions such as accepting Treasury debt at the discount window or in open market operations to settle markets, which are part of the Fed’s regular portfolio of activities.

Minutes of the Fed’s Jan. 29-30 policy meeting early this year included another interesting nugget which seemed to expand the Fed’s willingness to intervene in short-term lending markets during a crisis. At that meeting Fed officials authorized the New York Fed’s market desk to intervene in these markets to address “temporary” or “highly unusual” disruptions, when instructed by the Fed’s chairman. The move was put in place to address disruptions in “repo” markets last year after hurricane Sandy shut these markets down. The policy remains in place today.

Besides these scattered clues, the Fed has said little about what it would do if a government-imposed disaster were to strike the Treasury market. People familiar with the Fed’s deliberations say officials have been quieted by political calculations — the Treasury has been deeply reluctant to signal any intervention that might encourage congressional Republicans to try allowing a debt ceiling crisis.

Such a crisis was averted in October by a last minute deal. But another challenge could emerge in February or March, when the next debt ceiling deadline hits. With a lull in the drama, the Fed might see the minutes as an opportunity to quietly drop some fresh clues.

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